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MAKING CENTS OUT OF THE NEWS
Blog #28
(September 1st, 2011)
Life-Jacket Speculation in the Stock Market
By Tom McAllister, CFP®
Last month at a delightful lunch I shared with two “shipmates” I met on a transatlantic cruise, the conversation turned to the stock market. One of my companions, a retired mortician, commented vociferously, “The stock market is nothing but a crap shoot, you might as well just go to Vegas!”
Empathizing with his frustration, I admitted that in the preceding few years, the market had been tumultuous and not that rewarding to investors, adding that it is indeed possible to speculate, and even gamble, in the stock market. Upon reflection, I realized that more than more than half the daily volume on the New York Stock Exchange may consist of short term trading, which is, by definition, speculation.
At the same time, I pointed out there is a huge difference between investing in stocks and frequenting casinos. For starters, stocks over the years have consistently grown in value and dividends, an average of more than nine percent per year. Long-term odds, therefore, favor the investor.
Gambling, on the other hand, is at best a zero sum game. This means that, if one gambler wins at a game, someone else must lose an equal amount. At casinos, the odds are heavily stacked against the players. In fact, I always recommend, upon entering a casino, looking around the room, noticing the nice décor, the well dressed, good looking staff, and the “perks” available, such as free drinks or entertainment. The operative question at that point is “Who is paying for all this?” The answer is never the casino owners or the shareholders. (Skilled card players, such as my late father, can and do often win in private games, but if the “house” takes ten percent of the pot, that revenue comes from the few skilled players, with the majority of gamblers footing the bill.)
At McAllister Financial, my money managers and I utilize and promote long term investing, never gambling or speculating. We do not offer hedge funds, nor do we recommend leverage, which means borrowing additional funds to invest in the market. Instead, we attempt to buy quality stocks at good prices, as measured against a company’s earnings outlook going forward for the next several years. When we buy a stock for our investors we usually expect to hold it for several years. Often, a stock becomes a “core holding” for us and is rarely sold! On the other hand, we constantly look to “weed our garden.” If it appears a stock we bought was a mistake, for whatever reason, we daily weigh our options to sell it and move on to better ideas.
If we’ve made a good choice and the stock does well, it will often get to the point where, in our opinion, it becomes overpriced versus the market or its peer group. At that point we may sell out the position, or perhaps reduce it to reflect a lower percentage of the clients’ portfolio holdings.
Short-term speculation in the stock market, by contrast, is an activity we recommend against, with day trading especially a “no-no”. Commissions and “spreads” eat up all or most of your profits even if you are correct in most of your moves. In fact, portfolio turnover of more than 50% annually should be avoided by investors.
An exception to this turnover rule might be the strategy of writing covered calls on stocks you already own. A call is an option to buy at stock at a specific price for a specific time span, generally 30 days to a year or even two. Those writing (selling) an option get a premium (fee) from the buyer of the call. Calls are traded on several exchanges and the call market is normally an efficient one. A call writing program will normally include selling calls on a position several times a year. Premiums can, and often do, add five percent or more to your annual return.
Are there any negatives to call writing? Yes, because the call puts a limitation on the amount you make if your stock moves sharply upward. (Calls are not normally exercised, so it is rare that you lose your position.) If the price of the stock moves above the call price, the option will go up step by step, thus limiting your profit on the position. Calls either expire worthless, or are bought back just prior to expiration. Premiums are regular income for tax purposes.
Most investors would be best served by hiring an experienced investment manager or options broker to handle their option investing, and our investment managers offer this very service.
Covered call writing might well be called “speculation” while wearing a life jacket!
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